Understanding the current Fed and the problems with ftnt 14

September 27th, 2015 at 12:58 pm

Last week, Fed chair Janet Yellen delivered an important speech on how the Fed thinks about what has surfaced as one of their biggest challenges: understanding inflation dynamics. As you’d expect from Chair Y, it’s a (mostly) thoughtful and interesting exposition of the problem, which in no small part is a collapse of the Phillips Curve, as I’ve discussed in lots of places.

That is, as the job market has tightened up–we’re not at full employment but we surely moving in that direction–inflation has not accelerated…it’s decelerated. That’s the opposite of conventional economics wisdom and the motivation behind Chair Y’s effort to present their thinking about this critical development.

I’ve got a longer piece about that conundrum coming out tomorrow. For now, I just want to make two other points coming out of the speech, the first of which is, IMHO, particularly important if you want to get inside the thinking behind what looks to many of us on the outside as a “craze to raise.”

It is essential–ESSENTIAL, I tell you!–to wrap your head around Figure 6 from the speech, pasted in below. I’ll get to the figure in a sec, but note that Figure 1 from the speech shows another critical piece of information: the trend in inflation has been stable at around 2 percent since about the mid-1990s.

Source: Yellen (2015)

Source: Yellen (2015)

The Fed strongly believes, with some good reason, that this stability is in no small part a function of expectations, or more plainly, the fact that they’ve convinced the public that they will aggressively and successfully use their policy tools to keep long-run inflation on that 2% trendline (see their figure 7 for evidence of anchored expectations).

Why that’s so important is seen in the above figure. The graphs in panel A show what happens in the case of a price shock when inflationary expectations are “unanchored,” meaning people don’t have faith in the Fed’s ability to hit their inflation target over the longer term. The upper left graph shows how a positive shock to import prices raise the price index. The upper right panel shows how four years (16 quarters) later, what was temporary shock morphed into an increase in annual inflation from 2 to 2.5%.

But when expectations are “well-anchored” as in the bottom panel, that same shock dissipates and inflation settles back into the longer-term trend everyone expects it to be at.

Yellen elaborates on how important this anchoring is to their mission:

…the presence of well-anchored inflation expectations greatly enhances a central bank’s ability to pursue both of its objectives–namely, price stability and full employment. Because temporary shifts in the rate of change of import prices or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation. As a result, the central bank can “look through” such short-run inflationary disturbances in setting monetary policy, allowing it to focus on returning the economy to full employment without placing price stability at risk. Indeed, the Federal Reserve has done just that in setting monetary policy over the past decade or more.

The Fed is convinced that the stable trend is a function of monetary policy anchoring expectations. In this regard, the best way to understand what they are up to is  recognize they live in fear of the dynamics you see in panel A. Conversely, they live to promote and sustain the dynamics in panel b.

One interpretation of all this is that the craze to raise is a form of anchor insurance. There’s definitely some logic to this, but it’s also problematic in that remember, they’re missing on the downside (undershooting their target) and any tightening threatens to exacerbate that problem. Ironically then, acting to anchor expectations could, by exacerbating the current dis-inflation (slowing price growth), backfire.

The problem with footnote 14

The reason I thought the speech was “mostly” thoughtful was because footnote 14 made little sense to me and seemed more like Fed word salad than a convincing explanation of an important point. For reasons I’ll get more into in tomorrow’s piece, the Fed should, at some point, consider setting an inflation target of 4% instead of 2%. (I say “at some point” because doing so now when they’re having such trouble hitting 2% wouldn’t make a lot of sense. Also, see Larry Ball on this point.)

In footnote 14, Chair Y explains why raising the inflation target is a bad idea. Here’s the ftnt with annotated comments in bold.

Blanchard, Dell’Ariccia and Mauro (2010), among others, have recently suggested that central banks should consider raising their inflation targets, on the grounds that conditions since the financial crisis have demonstrated that monetary policy is more constrained by the effective lower bound (ELB) on nominal interest rates than was originally estimated. Ball (2013), for example, has proposed 4 percent as a more appropriate target for the FOMC. While it is certainly true that earlier analyses of ELB costs significantly underestimated the likelihood of severe recessions and slow recoveries of the sort recently experienced in the United States and elsewhere (see Chung and others, 2012), it is also the case that these analyses did not take into account central banks’ ability to use large-scale asset purchases and other unconventional tools to mitigate the costs arising from the ELB constraint.

THERE’S ABSOLUTELY NO QUANTITATIVE COMPARISON BETWEEN THE DAMAGE OF BEING STUCK AT THE ZERO LOWER BOUND AND THE BENEFITS OF QE OR FORWARD GUIDANCE INTERVENTIONS. THE ANALOGY PUTS A BANDAID ON A SHARK BITE.

In addition, it is not obvious that a modestly higher target rate of inflation would have greatly increased the Federal Reserve’s ability to support real activity in the special conditions that prevailed in the wake of the financial crisis, when some of the channels through which lower interest rates stimulate aggregate spending, such as housing construction, were probably attenuated.

THE ARGUMENT HERE IS THAT LOWER REAL INTEREST RATES WOULDN’T HAVE HELPED DUE TO DELEVERAGING CYCLE. BUT HIGHER INFLATION WOULD HASTEN THAT CYCLE AND AGAIN, THE ISSUE IS AVOIDING THE ZLB WHICH THE FED SHOULD STRIVE FOR EVEN MORE IF THE DELEVERAGING POINT IS TRUE (SINCE THEY NEED MORE, NOT LESS, FIREPOWER IF THAT’S WHAT’S HAPPENING).

Beyond these tactical considerations, however, changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation at any level because it might lead people to suspect that the target could be changed opportunistically in the future. If so, then the key benefits of stable inflation expectations discussed below–an increased ability of monetary policy to fight economic downturns without sacrificing price stability–might be lost.

WHAT?! THIS IMPLIES THAT THEY CAN NEVER CHANGE THEIR TARGET.

Moreover, if the purpose of a higher inflation target is to increase the ability of central banks to deal with the severe recessions that follow financial crises, then a better strategic approach might be to rely on more vigorous supervisory and macroprudential policies to reduce the likelihood of such events.

ABSOLUTELY. BUT THEY MUST DO SO WHATEVER THEIR INFLATION TARGET IS.

Finally, targeting inflation in the vicinity of 4 percent or higher would stretch the meaning of “stable prices” in the Federal Reserve Act.

HUH?! IF YOU CAN ANCHOR AT 2%, YOU CAN ANCHOR AT 4%. THE LAW SAYS ABSOLUTELY NOTHING RE A PARTICULAR TARGET.

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7 comments in reply to "Understanding the current Fed and the problems with ftnt 14"

  1. Robert Salzberg says:

    From Yellen’s footnote #29:

    “More generally, movements in labor costs no longer appear to be an especially good guide to future price movements.”

    Is this the coup de grace for the Phillips Curve?

    I also sensed a strong overstatement of how much Fed policy plays in price inflation. Aren’t the more important anchored expectations that Capital will continue to suppress wage growth aided and abetted by governments that would rather sign trade deals that increase corporate profits than address problems like currency manipulation, international tax havens, or instituting a global FTT for infrastructure development?

    http://www.washingtonpost.com/news/wonkblog/wp/2015/09/25/the-hidden-messages-in-janet-yellens-big-speech/


  2. Mark says:

    I’m surprised to see you say that it wouldn’t help to raise the inflation target from 2% to 4%, given that inflation is currently below the 2% target.

    It seems like announcing a target change now would fall under Krugman’s ‘regime change’ theory, or his theory of ‘credibly commiting to be irresponsible in the future’. I’m not an economist, but I thought the idea was to raise future inflation expectation, which would help induce inflation now.


    • Jared Bernstein says:

      I’ve long supported the higher target. But hard to be credibly uncredible re 4 if you’re not hitting 2!


      • Richard Solomon says:

        I agree with Jared. Why introduce more info/uncertainty into the situation at this point? I think it’s better to wait and see until the time we actually get to 2% inflation. THAT may still be some time off.


        • Tom_in_MN says:

          Expectations! That’s the point here. Raise the target and people will get worried about future prices and start spending now. It does not matter that we aren’t near 2% yet. And considering they will raise rates to stay below target when exactly would you have them raise the target? It’s much more responsible to raise the target when you aren’t exceeding it.

          I view this as progress. Yellen is addressing the 4% solution. Now we just need her thinking to come around. I just hope their attempt to raise rates without raising the target is not too disastrous, as it appears they are going to need to be forced back to the ZLB before they seriously considerly it.


  3. Richard Serlin says:

    “Beyond these tactical considerations, however, changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation”

    I’d add to what you said, this. Economists, of all people, should do cost-benefit analyses, not cost-cost, or benefit-benefit analyses. That there is some cost to credibility, and stability of expectations, of changing the target does not mean you should never do it; we keep 2% for the next 200 years, 1,000 years,… As a good economist you ask how big is that cost, and are there benefits that outweigh it. And you try to quantify all of the costs and benefits well, short, medium, long, and very long term, with an appropriate discount rate for the situation, its risk; and so on.

    Here, having so much less ability to fight recessions, depressions, lost decades, financial crisis, lowflation and deflation, is really an enormous, terrible cost of keeping the inflation target so low. I don’t see anywhere near that cost from decreased credibility, and stability of expectations, from just a one-time raise to 4%, or even possibly 5. It could be made clear, and I think it would be pretty clear, that this was not due to a shift to loose money, financing government, etc. You could make a pretty clear and compelling case that this is only because of the terrible track record around the world of a 2% target when it comes to fighting slumps.

    Moreover, does history show that it’s that hard, and takes that long, to establish credibility? Fed credibility was far lower in the 1970s than it would ever be if the Fed changed its target now. Yet, it took maybe only 5-10 years for the Fed to establish strong credibility and stability. You weigh that cost against the cost of staying forever with 2%, and forever having recessions and depressions and lost decades and financial crises be far more severe and long lasting? The short-term cost of changing looks tiny compared to the permanent benefit of a higher target.

    Finally, I’ll add this thought. I seriously wonder how much of central bank attitudes are due to the fact that these people are like Stanley Fischer; LSE, MIT, tenure, never has had any risk ever, zero, of being unemployed with a family depending on him. Because in their cost benefit analyses they seem to weigh the costs of excess inflation so high relative to the costs of excess unemployment. It stuns me when you really think of how devastating it is for a family to loose an income in this day and age, with so little savings and safety net. This is something that those making these decisions have never, and will never, personally have to stress over and fear. Yet they do experience the discomfort of inflation, and have lived through high inflation in the 70’s.


  4. Tom_in_MN says:

    And one more thing: Who here believes that the fed would see 2.5% inflation and say “well expectations are anchored so no need to raise rates”? These are the get ahead of the trend folks. They’d never give the anchored case in the plots a chance to play out.


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